Election Uncertainty Keep Stocks Down, Despite Strong Economic Data
Earnings season is drawing to a close, with 80% of companies in the S&P 500 having reported their earnings for the third quarter as of the end of last week. The most positive results have come from the financials sector, which beat expectations for both revenues and earnings and outperformed the S&P 500. Financials benefited from strong capital markets activity—fixed income trading, in particular—and accelerating loan growth.
Economic data released last week showed better-than-expected economic sentiment throughout the world, as represented by Purchasing Manager Index (PMI) reports that measure activity in manufacturing. PMI readings from China, the eurozone, the UK and even Russia were surprisingly strong—which may indicate continued improvement in economies across the globe.
In the U.S., The Institute for Supply Management (ISM) Manufacturing survey was higher than expected in October following a surprisingly large jump in September. In contrast, however, the ISM Non-Manufacturing survey that measures activity in the services sector was weaker than investors anticipated. The ISM noted that some survey participants made comments about the uncertainty of the impact of the upcoming U.S. presidential election.
In addition, three of the world’s most important central banks—the U.S. Federal Reserve, the Bank of Japan and the European Central Bank—held monetary policy meetings last week. All three central banks kept their policies unchanged. However, there is currently a 78% market-implied probability that the Fed will raise interest rates at its December meeting.
GAIN: Active Asset Allocation
Risk assets such as equities fell for the second week in a row last week, as investors prepared for the results of the Presidential election. Although the energy sector moved lower due to declining oil prices, the financials sector performed relatively well and helped value investments outperform growth investments. While we continue to favor growth- style investments overall, the financials sector is becoming more attractive as interest rates rise modestly.
The CBOE Volatility Index (VIX), which measures expected future volatility, moved above 20 for the first time since the end of June, but bonds were basically flat on the week. The Federal Reserve Board’s comments continued to suggest a possible December interest rate hike.
PROTECT: Risk Assist
Similar to what occurred during the lead up to the UK’s Brexit vote, the cost of options has risen sharply as the U.S. election approaches—even as actual realized volatility has remained muted. For example, the CBOE Volatility Index (VIX) rose from 14 to 22 during the past week. However, the level of realized volatility on the S&P 500 is at just 5.
A more nuanced view of current conditions can be seen using a metric called Implied Correlation (IC), which measures the price of options on an entire index relative to the price of options on the individual stocks in that index. When IC moves higher, index options are getting more expensive relative to options on the underlying constituents of that index. Over the past week, the IC of the S&P 500 jumped from 0.40 to 0.65—a move suggesting that investors looking to hedge are favoring big, macro-level hedges at any cost. This is an atypical development during earnings season, when individual stocks and sectors generally dominate the volatility landscape.
In the Risk Assist models, we continue to be positioned for some additional volatility and have some hedges in place in the event that Donald Trump wins the election. If that occurs, one scenario we’ve prepared for is that stocks could potentially drop and then recover shortly thereafter (along the lines of what we saw post-Brexit).
SPEND: Real Spend
As the election approaches and uncertainty around central bank policies persist, many yield-focused investments have sold off. Consider the performance of these asset classes during the fourth quarter thus far:
- Long-term treasures are down nearly 4%
- Preferred stocks are down over 3%
- High yields are down nearly 2%
- Core-dividend stocks are down over 4%
- Utility stocks are down over 2% (and are the 2nd-most volatile sector behind energy)
- The real estate sector is down nearly 9%
Despite Real Spend’s focus on income, it is not yield-centric. Instead, Real Spend seeks to generate income from the capital appreciation of a broadly diversified portfolio of asset classes and investments in conjunction with a less risky and liquid spending reserve. While Real Spend does hold dividend stocks and preferred stocks, it also owns other asset classes that have helped to offset the recent underperformance of these yield-heavy investments.